Energy Regulation Weighs on U.S. Exchanges

IntercontinentalExchange Inc. (ICE) and CME Group Inc. (CME) have seen severe declines this week after new proposals for energy regulation were released. The restrictions are aimed at reducing volatility in energy prices which threaten to choke off economic growth in the global economy. Statements from the US commodities futures regulator (the CFTC) as well as from UK Prime Minister Gordon Brown call for limits to the positions speculative traders are allowed to take.

The argument made by the regulatory bodies is that energy speculators are helping to push the price of oil to unnaturally high levels. Many institutional traders with no natural exposure to oil prices have bought futures contracts representing significant holdings in oil and other commodities largely as a hedge against inflation. So in order to curb the recent rise in energy prices, regulators are seeking to place position size limits for non industrial traders. It is expected that reducing the level of exposure each trading entity can take will actually decrease the volatility in the markets and lead to lower prices for consumers and businesses that actually need to purchase oil or petroleum products.

According to Senator Byron Dorgan (a democrat from North Dakota), the measure is a good first step to curb “oil speculators looking for a quick buck at the expense of American consumers.” Ironically, this view of markets and economics flies in the face of conventional wisdom and could actually harm oil and other commodity market liquidity and increase the amount of volatility in these important exchanges.

Traditionally, free markets provide a mechanism for finding the true economic value of whatever asset is being traded. A large number of buyers and sellers makes for the most efficient price levels because the multitude of differing opinions and motivations will likely mirror the true level of supply and demand. When supply and demand meet at a particular price, all known economic variables are typically factored into the price of this particular commodity.

When prices on financial exchanges differ from the production or consumption economic dynamics, there is nearly always an arbitrage opportunity which will eventually drive prices back to equilibrium. For instance, if oil futures prices are unnaturally high, it is very easy for a drilling company to sell significant quantities of oil futures contracts at a high price and then deliver the oil (which was produced at a much lower cost) against these contracts. If prices were unnaturally low, a similar opportunity would exist for traders on the consumption side to buy future oil needs at a steeply discounted price. The ability to hedge and speculate over time will drive prices to their natural equilibrium which is dictated by supply and demand forces and not by regulation.

However, when regulators step in and attempt to influence the price of particular commodities, the law of unintended consequences will usually overshadow any positive outcome. Reducing the number of participants will almost certainly increase the price volatility which actually hurts consumers. With uncertainty surrounding oil prices, businesses will be less likely to make long-term plans for production or consumption - especially if they are prevented from hedging their exposure.

It should be noted that hedgers and speculators must co-exist in a market place in order for each participant to be successful. Speculation involves taking on risk with the expectation of a return in the future. On the other hand, hedging involves laying OFF risk and usually giving up some expected return in exchange for the business stability. If speculators are not allowed to take the other side of the trade so that hedgers can lay off exposure, the market will cease to function or will function with limited effectiveness. So while the regulators intent is likely to protect consumers from fluctuating prices, the action proposed will likely have a much different effect in the long run.

It is certainly true that oil prices have been more volatile in the last two years than nearly any other historical period. But the volatility is likely more a function of our uncertain economy rather than speculators pushing the price in one direction or the other. Mid year 2008, prices were at record highs as investors feared “peak oil” where the availability of world oil supplies were in question. However, the decreasing demand for energy as a result of the global recession caused oil prices to quickly drop. Arguably these prices were unnaturally low because they reflected the fear of a complete economic melt down.

As we work our way out of the fearful period, oil prices are rising but likely reflect a more accurate balance between the “peak oil” long-term supply issues and the weak economy short(er)-term demand issues. It is reasonable to see large fluctuations in prices given the true fundamental uncertainty in the market.

As regulations appear to be on the horizon, IntercontinentalExchange has been particularly hard hit because of its exposure to energy trading. However, the selling looks to be a bit overdone as ICE has many other products which bring in revenue and while energy trading may be muted, there will certainly still be a market for the futures and OTC contracts handled by ICE. The low price likely represents a buying opportunity and the ZachStocks Growth Model may soon add to its position in order to take advantage of the low price.

Disclosure: Author has a long position in the ZachStocks Growth Model.

Comments

[donzoab:]

The piece you overlook is all the event driven pressure from hedgefunds colluding against a particular market.
When multiple funds conspire to push in one direction, efficient markets collapse. Just look at what happened to the financial services industry as a result of all the short activity.
supply and demand does not always work in the short term when these aggressive large players get together. This unethical behavior is what should be regulated/prosecuted.

Jul 10 06:53 AM

[Andy1234:]

you can never have an efficient market......as all prices today will change with time.......as no one can predict the future. The only absolute is that prices will change with time......hence all efficient market theory must be incorrect....because no one can accurately predict the future. Furthermore.....everyone views history differently....while each person may view it with their own values/experiences/mat... equations....etc......nothing jives to the true value....as none of us are "the knowing".

Jul 10 09:03 AM

[Zachary Sch...:]

Donzoab - Do you really think this is an issue of price manipulation? Or is it simply many participants all seeing the writing on the wall and putting themselves in a position to profit? Either way, if the price moves too far in one direction, astute traders should be able to take the opposite side and benefit from recognizing mis-pricing. Price manipulation is certainly unethical. But trading for profits in volatile markets is simply part of our capitalistic society.

Sure Andy, I think there are definite problems with Efficient Market Hypothesis. But inefficient markets simply give us as traders an opportunity to profit from recognizing and trading based on incorrect price points. Saying that markets are not efficient and so therefore must be manipulated by the government is NOT a good solution. That just creates MORE inefficiencies.

zachstocks.com

Jul 10 10:24 AM

[radicall:]

I agree that markets are not efficient. I mean if they were efficient - how could the price for a stock fluctuate 500%+ in 3 months without any major fundamental shift?

As far as ICE itself is concerned - I think it is mispriced based on worries about oil trading regulation. it shouldn't affect trading revenues as much - in fact, when the OTC trading of derivatives begins - it should add to volumes.

Jul 14 03:37 PM

[dyson:]

Just like how real estate prices are driven to their "natural prices" by supply and demand?

Jul 28 01:05 PM

[Budlaw:]

I subscribe to the "Chicken Little" theory myself, some little hickup, halfway around the world, and Chicken little runs up and down the hallways, screaming, "we've got to raise oil prices".
How do we know, that the hickup wasn't prevoked, by some slick businessman, Can't happen?, the hell it can't ! I stop trusting business peole long time ago. Look at B. Madoff, and all the suckers he pulled in, and he was suppose to be on the up n' up.
Most oftenly, the cause of sudden rise in oil prices, doesn't pan out, and down go the prices again. That wouldn't be so bad, but, the local gas dealers raise their prices, in a heart beat. When prices go down, now thats different, maybe two, three days later, if then.
Yea, I'm just a little guy, and my voice doesn't mean squat, but, I watch the pain caused by your price manipulation, the families you hurt, who are ready hurting, and you guy's just stick it to them anyway, Nice ! I watch the oil reserve inventories closely, and there is a glut of oil, not being bought. With so many people out of work, and losing their homes because of it, you still keep right on twisting the screws. Why, because you don't give a sh@##.
As far as the unemployment figures put out by the Government, I don't trust those either ! They jive the numbers, anyway the chose, to make themselves look better. If the average joe, on the street is blind to your tactics, its because you make them that way. Smoke and mirriors, now you see it, now you don't.

Jul 28 05:18 PM